inflation–what’s important to know (ii)

The last time the US had a serious inflation problem was in the late 1970s. That’s more than forty years ago. Except for people who have spent considerable time in inflation-prone areas abroad, no one in the US under the age of, say, 55 has had any practical experience with inflation. Perhaps this accounts for much of the unhelpful discussion of the topic on financial tv and in the financial press.

There are always changes in the price of individual things. PS5s, for example, are in short supply, so potential buyers may have to pay a price far above list from a reseller to snag one. But that’s price gouging, not inflation. The copper price is rising. But that’s due in large part to mine development decisions made maybe ten years ago. And copper is a very tiny part of the whole economy. So that’s not inflation, either. There’s a front page story in the Washington Post this weekend about how expensive used cars became last year as affluent city dwellers fled the pandemic for rural areas. Inflation? No. That could just as easily have been about hand sanitizer–except it’s much easier to see the current glut of sanitizer in just about any store.

Inflation is a persistent rise in the level of overall prices.

Two key characteristics:

–in OECD countries, inflation is virtually always a result of wage inflation, caused by government applying too much stimulus to a booming economy (not where we are now), and

–inflation causes a change in consumer behavior as the expectation that prices will continue to rise inexorably takes hold. People and companies begin to hoard everything, either on the the idea that any item will be just that much more expensive tomorrow, and, for companies, that they can generate future profits just from maintaining fat inventories. People also shift their investing away from bonds toward tangible items like real estate or gold or silver or foreign currency, that they see as protecting them against inflation. In extreme cases, people begin to buy anything tangible, like a couple of used cars to put on blocks in the backyard (this actually happened in Brazil), to preserve their purchasing power. Even better, borrow money from a bank to buy the cars and you’ll also benefit from the falling real value of the loan.

Once inflation expectations develop, they’re very hard to eradicate, and can result in a chronic misallocation of resources.

one thing worse–deflation

The only thing worse than runaway inflation is deflation, a persistent decline in the price level. The thing that makes deflation so scary is that while curing runaway inflation is a long and painful process, at least economists know what to do to fix things. Not so for deflation.

the US today

In the ten years between the financial crisis and the pandemic, inflation in the US, measured by the Consumer Price Index (CPI) averaged about 1.6%/year. The ten years before the crisis, inflation had averaged about a percentage point higher, at 2.5%/year. During the more recent post-crisis period, domestic macroeconomists’ main worry has been about how close the US has been to having deflation and the inability of government policy to move the economy farther away from the zero line. That’s despite a very large tax cut and running a relatively stimulative money policy. Yes, the Trump administration’s reprise of the disastrous Tokyo economic policy of the 1990s may have been a factor in this. But while that’s now being gradually reversed, it’s unclear how much damage is still being done. Even if there’s none, however, the possibility of deflation is still front and center for economists. Because of that, it seems to me the last thing the monetary authorities are thinking about is tightening before we see a convincing move in inflation to the upside. To paraphrase Mr. Powell, let’s see inflation get well above 2% and show signs of rising further before we can declare we’re past the deflation danger and can resume normal policy.

Some prominent hedge fund managers (a group that has been steadily underperforming for almost twenty years) have been making headline-catching pronouncements about the threat of hyperinflation (the used-cars-in the-back-yard kind) in the US. It’s hard to see what the basis is for their claims, other than to get press attention and, implicitly, third-party endorsement for their competence as investors. Hyperinflation is pricing rising 10% a week. Powell is talking about letting domestic inflation creep above 2% a year before clamping down.

so, why is the stock market so wobbly at present?

My one-sentence answer is that we’re returning to normal. Pre-pandemic, the 10-year Treasury was yielding 1.80%. The yield fell to 0.52% last August, before gradually rebounding to about 0.9% as the election neared. We were at 1.1% at the Biden inauguration and have been rising slowly, but steadily since.

There appear to have been technical wobbles recently. For one, the Treasury is beginning to raise new debt at longer maturities than during the prior administration, which has put upward pressure on those longer-maturity bonds. It’s also been reported that at the end of the month commercial banks will lose some ability to trade Treasuries, making the banks less eager to buy new government bonds. Those two issues aside, it may also be that at current yields there isn’t an overpowering appetite for longer-maturity Treasuries.

I’m a stock person. I’ve never run a fixed income portfolio. So I don’t know enough about bonds to be sure how important the previous paragraph is. But that may not matter.

The one thing I’m hanging my portfolio hat on: pre-pandemic, the 10-year was yielding 1.8%. I’ve got to think that in an economy returning to normal the first significant milestone is back at 1.8%. We’re yielding 1.64% now vs. 0.93% at the end of last December. So we’re most of the way there already.

I don’t think this is the end of the road for higher yields. Another way of looking at fixed income is that investors presumably require inflation protection + at least some real yield when they buy bonds. If the Fed wants to see inflation at 2% or 2%+ before it steps in to cool things down (and I think the deflation threat argues it will), then the end point for the 10-year may be 2.2% or higher.

My stock-guy assessment is that true normal for the economy could easily be a year away and that the bond market typically doesn’t look that far ahead. So my guess is that we stay at 1.8% for a while. That could be wishful thinking, though. But if that guess is correct, I think we’ll see the stock market continue to sharpen its focus on reopening beneficiaries while moving generally sideways. If rates continue to power higher toward 2%, it seems to me that the overall market will continue to have its current saggy feel but that the rotation toward reopening winners will, if anything, move more quickly.

Treasury yields and stock PEs

A much-too-simple model (but still one worth something) of the relationship between stocks and bonds equates the interest yield on bonds with the earnings yield (1/PE) of stocks. If we take the 10-year as a proxy for bonds, then last summer’s 0.52% yield implied a PE of 192 for the S&P. The 0.93% of last December equates to a PE of 108. The current 1.64% implies a PE of 61. At 1.8%, the implied PE is 56. At 2.5%, it’s 40.

The absolute figures may be nonsensical, but even if so, I think two important points can be made:

as interest rates rise, PE multiples contract; and

–if 1.8% is really the next stopping place for bond yields, then most of the damage to stocks has already been done. Not all, but most.

A closing thought: according to Wall Street Journal figures, the forward (meaning using calendar year 2021 earnings) PE on the S&P 500 is currently 22.3x. Using trailing 12 months earnings, the PE is 45x. We have to take the 2021 eps figures with a grain of salt, particularly since they are projecting a doubling of earnings. But the numbers illustrate the relative attractiveness of stocks in an environment like the current one: rising rates push PEs down, but rising earnings push stock prices up. Also, if the WSJ numbers turn out to be anywhere near correct, stocks already more than discount likely near-term interest rate rises.

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